Concentration and Long Term – Shift to the outcome and away from the process

As investors, we love to quote Warren Buffett. I have always thought of the reason and more importantly the obsession towards it and my hypothesis is that it makes us sound smart, and it gives the reader a sense of authenticity when we quote THE investor who has managed money over long periods of time.

However, quoting Warren and looking at his outcome would miss the bigger picture around how the outcome fell into place and more importantly, the process that led to the outcome.

While we live in an outcome driven world, failing to understand the process will ensure that the outcome cannot be replicated. Be it in sport or investing, its essential we realize the process (as the input) as its under our control than the outcome (as the output) which may not be always fully under our control.

There are two aspects of Warren’s teaching that I always hear every investor quote – you need to own concentrated holdings to generate returns (a consequence of understanding what you own or put another way, put all your eggs in a few baskets and watch them closely) and we need to invest long-term for consistent returns and compounding.

While both are important lessons in investing, its important to understand why Warren prescribes this and how does he achieve this in his own portfolio.

Understanding Concentration

I have read and re-read multiple letters of Warren (his letters are publicly available for anyone) and he consistently speaks of concentration, circle of competence and sticking with your winners. However, its important to understand that concentration for him is not a starting point. What does this mean?

Warren’s portfolio has concentration as an outcome and not as a starting point. He does not construct a portfolio by owning 5-7 businesses (starting concentration). However, the beauty of his portfolio has been his holding power of the businesses he owns (he tends to own his winners longer). What this effectively means is that he does not exit the businesses that are doing well (because it has shown him 100% gains). Over long periods of time, a narrow set of businesses (and Warren admits that many a time his conviction gets built over time) tend to concentrate and give him 80% of the portfolio returns. This is very different from what investors expect of owning 5-7 businesses as a starting point and generating outsized returns (It’s the difference between process vs outcome).

Understanding Churn and Long-term

Any good literature (I define good as coming from an investor who has managed money over 15+ years) advocates and speaks about the merit of long-term investing. It is well written and acknowledged that long-term allows an investor to compound wealth rather than make money (there is a big difference between the two concepts – compounding wealth is repeatable and scalable, while making money is not).

However, studying data shows you that investors have short durations , be it in the funds they invest in and the businesses they own. In this article, I am not looking to endeavour into the reasons for this. I would rather spend time looking at Warren himself around what duration meant to him. The table below is an extract from a study which analyses all of Warren’s investments till 2006 (for a period of over 20+ years).

Table 1 : Study and Breakdown of Warren’s holdings and Investments alongside the duration held till 2006

As can be seen from the table, Warren bought ~230 businesses but his concentration came from 7 of them. Of course, a naïve analysis could be to focus on the outcome and conclude that he could have bought the 7, but unfortunately you know about the 7 only with the benefit of hindsight.

The reason he continues to be a legend is his ability to risk manage and to cut losses as the thesis changes. While clients may call these mistakes, the prudent risk manager in him makes him acknowledge this and cut them (easy to say and hard to do).

Again, concentration (knowing your holdings) and long-term investing are necessary outcomes for successful investing but equally (if not more) important is to appreciate the process that leads to this. It is important an investor understand the difference between process and outcome to acknowledge this.

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